Lesson 1 of 8 · All lessons in this module
- Credit risk and where it comes from
- Expected loss: POD × LGDVideo lesson
- What drives default risk and recovery
- Credit ratings: uses and limits
- Why spreads move: macro and issuer factors
- Inside the spread: credit and liquidity
- How spread changes move bond pricesVideo lesson
- Integrated cases: reading a corporate quote
Free lesson: the first lesson of every module is open to everyone.
Lesson 1 of 8 · 12 min
Credit risk and where it comes from
Credit risk is the chance of losing money because a borrower does not pay interest and principal in full and on time, and it starts with where the borrower's cash comes from.
In short
- Credit risk: the risk of economic loss when a borrower fails to make full and timely payments. A borrower that misses a promised payment is in default.
- Lenders feel it in several ways: lost principal or interest, late payments, collateral that sells for too little, and legal and collection costs.
- The Cs of credit: five bottom-up, borrower-specific factors (capacity, capital, collateral, covenants, character) and three top-down factors (conditions, country, currency).
- Corporate debt is repaid mainly from operating cash flow; secured debt adds pledged collateral as a second source. Sovereign debt is repaid mainly from taxes.
- Illiquid (cannot raise cash to pay now) is not the same as insolvent (assets worth less than liabilities).
What credit risk is
A bond or loan is a promise: pay these coupons on these dates and repay the principal at maturity. Credit risk is the risk that the promise is broken, so the lender suffers an economic loss. It is a kind of performance risk in a contract.
When a borrower fails to make a promised interest or principal payment, it is in default. But credit risk exists long before any default. The investor demands compensation up front for the loss it expects over the life of the contract.
Credit risk is not static. It depends on the borrower's own situation and on the wider economy, and both change over the life of the bond. That is why credit-risky bonds are repriced continuously.
The damage to a lender is wider than a missed coupon. It can lose some or all of its principal and interest, wait longer for its money, sell collateral below the value of its claim, or pay lawyers and collectors. Those shortfalls can in turn squeeze the lender's own ability to pay its debts.
The Cs of credit analysis
A traditional checklist for judging creditworthiness is the Cs of credit. Five of them are bottom-up: they describe the individual borrower. Three are top-down: they describe the environment every borrower in a market faces.
Capacity and capital are mostly quantitative and come from the financial statements. Collateral, covenants and character are mostly qualitative and are judged from track record, lending relationships and management's reputation.
| C | Type | Question it asks |
|---|---|---|
| Capacity | Bottom-up | Can the borrower make its debt payments on time? |
| Capital | Bottom-up | What other resources reduce its reliance on debt? |
| Collateral | Bottom-up | What are the assets backing the debt worth, and how good are they? |
| Covenants | Bottom-up | What legal terms in the debt agreement must the issuer obey? |
| Character | Bottom-up | How good is management, and how willing is it to repay? |
| Conditions | Top-down | How do the economy, competition and business climate affect servicing or refinancing debt? |
| Country | Top-down | What geopolitical, legal and political setting do issuers in this jurisdiction face? |
| Currency | Top-down | Do exchange-rate moves hit cash flows, or is the debt in a foreign currency? |
Memory hook: the top-down Cs (conditions, country, currency) apply to every borrower in the market, so they can push many issuers' credit quality in the same direction at once.
Sources of repayment
Whatever goes wrong, a default ultimately comes down to one thing: not enough cash to make a payment that is due. So credit analysis asks how the borrower generates cash, when and how it spends it, and what could stop it from repaying.
For an unsecured corporate bond the primary source of repayment is the cash the business generates. A secured bond has the same primary source, but it is also backed by specific collateral the issuer has pledged. If the cash flow fails, selling that collateral is a secondary source of repayment.
A sovereign borrower repays mainly from taxes: personal and corporate income taxes, sales tax and VAT, plus tariffs and fees. When a government borrows in a currency other than its own, its ability to earn that currency (through its economic and institutional strength, policy choices and exchange-rate regime) also matters.
| Borrower | Primary source | Secondary sources | Typical credit risks |
|---|---|---|---|
| Corporate | Business operations; investing and financing activities | Asset sales, divestitures, new debt or equity | Recession, strategic or market shifts, more competition, weaker pricing power, shrinking margins, heavy debt service |
| Sovereign or public entity | Income, sales, VAT, capital-gains and wealth taxes; tariffs and fees | New debt, sale of public assets, privatisation | Recession, political uncertainty, heavy debt service, expansionary policy, deficits, tax cuts, weak tax collection |
Illiquid versus insolvent
A borrower that cannot raise the cash to meet a payment as it falls due is illiquid. It may be unable to draw on credit lines, sell assets quickly or find new funding in time.
An insolvent borrower is in a deeper hole: its assets are worth less than its liabilities. An illiquid borrower may be perfectly solvent on paper and still default, simply because the cash is not available on the payment date.
Investors compare credit risk in two directions: across different borrowers at similar maturities, and across maturities for the same borrower. The next lesson gives the tool for doing both: expected loss.
Worked examples
Example 1 Sorting the Cs
An analyst reviewing Fjordline Shipping notes: (1) interest cover has fallen; (2) the loan agreement caps further borrowing; (3) the vessels pledged to lenders have lost value; (4) most revenue is in USD while the debt is in NOK; (5) freight rates are falling across the industry. Which C does each observation relate to, and which are top-down?
Example 2 Who gets paid from what
Brightwater Foods has unsecured notes outstanding. Tervola Mining has notes secured by a specific copper mine. The Republic of Aurelia has bonds outstanding in its own currency. What is the primary source of repayment for each, and who has a secondary source?
On the exam
Expect definitional questions: what credit risk is (and that it exists before any default), which C a fact belongs to, the primary versus secondary source of repayment for secured, unsecured and sovereign debt, and illiquid versus insolvent.
- Credit risk is not 'activated' by default. Expected loss exists, and is priced, before anything goes wrong.
- For secured debt the primary source of repayment is still operating cash flow; the collateral is the secondary source.
- Conditions, country and currency are top-down; the other five Cs are bottom-up.
- An illiquid borrower can default even though its assets exceed its liabilities.
Check yourself
Q1Which of the following Cs of credit analysis is a top-down factor?
Q2The primary source of repayment for a corporate bond secured by a pledged factory is most likely:
Q3Valdera Retail has assets worth well above its liabilities but cannot raise cash in time to pay a coupon due tomorrow. Valdera is best described as:
Q4The main source of repayment for a sovereign government bond is:
Q5Which statement about credit risk is most accurate?
Answer the 5 questions: +10 XP for each one you get right first time.
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